There are a large number of different mortgage options on the market - all suited to different lifestyles and circumstances. It can be confusing understanding all the features of the different products and knowing which one is right for you. Do you go for an interest only mortgage or repayment? Do you need any special mortgage features? Should you fix your mortgage, and if so, for how long? We can help you with the answers.
There are many different types of mortgage products – Discount, Capped, Fixed Rate, Tracker, Cash Back, Flexible/CAM, including those aimed at specific sections of the market including First Time Buyer, and Buy to Let. If you're wondering which type of mortgage might best suit you, then try our What mortgage suits me calculator which can help you look at the different options.
When choosing a mortgage you need to look at:
· Do you want a repayment or interest only mortgage?
· What type of interest rate option would suit you – tracker, fixed, capped?
· What other special features might appeal / suit you?
The key decision you have to make is between a repayment or interest only mortgage - you are either paying only the interest on the money you have borrowed, or both the interest and a portion of the capital.
With a repayment mortgage your monthly repayments cover both capital and interest on the loan. No other repayment vehicle is needed, but your lender may insist on life insurance in case you die before the mortgage is cleared.
On the plus side, a repayment mortgage is simple, straightforward and easy to understand. It also avoids the risk of investing in the stock market for your repayment vehicle.
However, unlike a pension, ISA or endowment mortgage, repayment loans do not give you the opportunity to benefit from a rising stock market. Also, when remortgaging, people often choose another 25 year repayment mortgage, to keep the initial monthly costs down. This means that the overall total period of your mortgage debts combined increases over time.
With an interest only mortgage, your monthly payments to the lender cover only the interest on the loan (i.e., they don't repay any of the capital). The full amount of the loan has to be repaid to the lender at the end of the term.
To ensure you can make this final payment, you invest additional funds in investments which are designed to generate enough (preferably more than enough) capital to repay the loan at the end of the term.
On the plus side, you can choose from a variety of investment vehicles, some of which can have tax advantages. And should you move or remortgage, your investment vehicle can usually be reallocated to the new mortgage.
However, unlike a repayment mortgage, the total amount of your debt does not reduce over time. And there is no guarantee that your chosen investment vehicle will grow sufficiently to repay your loan (although you can usually top up your contributions to investments as you go along if this looks likely to be the case).
Once you've decided on whether you are going to make payments on the capital or not, you need to turn your mind to interest rate options. There are many different ways of calculating the interest due - all of which have their advantages and disadvantages, depending on your circumstances. Add to this a number of other special types of mortgages - and you have a lot to choose from.
The simplest form of loan is one which sets its interest rate according to the lender's standard variable rate, or SVR. With a loan like this, your interest payments are likely to rise or fall every time there is a change in the Bank of England's base rate. However, lenders don't always pass on the change in Base Rate - this can be to your disadvantage if the rate falls but your interest rate doesn't.
Most borrowers are transferred to their lender's SVR once their initial, promotional rate period comes to an end.
There are usually no early repayment charges on these loans.
The unpredictability of interest rate movements makes it hard to plan your finances, and the costs of your mortgage may rise rapidly if interest rates go up.
A discount mortgage offers a reduction ("discount") of a given amount on the lender's standard variable rate. If the SVR changes, the rate you pay will fluctuate in line with the change but at the same level of discount (e.g. 0.5% below SVR).
Usually, the greater the discount is the shorter the period of discount will be. After the discount finishes, the loan reverts in most cases to the lender's SVR.
You can make a significant saving on the standard variable rate.
Discount mortgages often incorporate significant early repayment charges, which may make it expensive for you to remortgage to another rate or lender.
A fixed rate loan charges a set rate of interest for a predetermined period, and then usually reverts to the lender's standard variable rate. The fixed rate will often be very competitive, however when you revert to the lender's standard variable rate you'll find that this is much higher.
A fixed rate loan offers you the security of knowing how much you'll be repaying during the initial period which can make budgeting much easier.
If the Bank Base Rate is dropping, your fixed rate may actually prove to be more expensive than a discount or tracker rate. E.g. you may tie in to a fixed rate which is the "best ever" but the market may continue to drop, leaving you on a higher rate but unable to move due to early repayment charges.
A capped rate will not rise above a certain level for the cap period - offering similar security to the fixed rate. You can have confidence that your interest rate will not exceed the cap, whatever happens to the lender's standard variable rate. The initial rate is usually competitive, however the deal will often also incorporate early repayment charges.
A capped rate offers you the security of knowing that your monthly payments will not rise beyond a certain level during the initial rate period, and therefore it will be easier for you to budget than it would were you on a tracker or variable rate.
As a payback for the security of the capped rate, rates are often higher than a fixed rate and the initial cap term seldom lasts longer than 2 or 3 years.
A tracker rate gives you the certainty of knowing the rate you pay will move automatically in line with Bank Base Rates. You benefit straight away from any reduction in Bank Base Rate, even if the lender delays reducing its standard variable rate to reflect the reduction.
Tracker rates often track Bank Base Rate by a certain percentage, e.g. Bank Base plus 0.75% for the full term of the mortgage.
Many tracker products also offer flexible terms.
A tracker rate means that you immediately benefit from any reduction in Bank Base Rate - which is particularly beneficial in times of low Base Rates.
If the Bank Base Rate increases, your interest rate will also move up, while those on capped or fixed rates keep their low rate for longer.
As well as having one of the above interest rate features, mortgages often offer a number of other options, which can help you make the decision on what is best for you and your circumstances.
A flexible mortgage allows you to vary your monthly repayments. Depending on the flexibility of the particular mortgage, you can, without charge:
The flexibility is conditional - usually you have to follow (or exceed) a predetermined repayment schedule.
TOP TIP: Look out for a mortgage which may not officially be "flexible" but still allows the ability to make overpayments.
A cashback mortgage pays out an upfront lump sum when the mortgage is taken out. This sum can then by used to pay, for example, for home furnishings or pay off a credit card debt.
You get cash just when you need it, at a relatively competitive rate compared to most credit cards or other short-term loans.
If you do take out a cashback mortgage you will often find that the interest rate is the lender's standard variable rate - the disadvantage of the cashback is the lack of flexibility or competitiveness on the interest rate.
A droplock mortgage is a discount or tracker mortgage, which has an option to switch to a fixed rate at any point within the initial discount or tracker period without paying any early repayment charges.
This provides an ideal way to benefit from base rates when they're low, with the option to switch easily to the protection of a fixed rate should interest rates look set to rise significantly.
Like current account mortgages, offset products allow you to offset the balance of your mortgage against any funds in a savings and/or current account held with the same lender, and pay interest (calculated on a daily basis) on the net balance between the accounts.
If you choose an interest only mortgage you will also need to arrange a repayment method to pay back the capital at the end of the mortgage. There are a number of different options available, including an endowment or a pension or an ISA.
With an endowment mortgage you make your monthly repayments of interest to the lender and as well as this, you make contributions to an insurance company to fund a savings plan. This savings plan aims to generate sufficient funds to pay off the capital at the end of your agreed mortgage term.
The savings plan can be "with profits", "unit-linked" or a combination of them both.
"With profits" policies pays two types of bonuses. A "reversionary" bonus is usually paid into the savings plan each year and, once awarded, is usually guaranteed provided the policy is still active on the maturity date. A "terminal" bonus is awarded on the policy maturity date and its size will depend on the performance of the fund over the lifetime of the policy.
With "unit-linked policies", the value is driven by the underlying value of the investments when the policy reaches maturity (but you can often swap into safer investments a few years earlier if you wish). If you die before the term is complete, the life insurance aspect of the endowment policy is used to clear the loan.
The good thing about an endowment repayment vehicle is that you can maintain the policy if you move house or change mortgage provider. Endowments can include some kind of life and critical illness cover which is usually cheaper than buying such cover separately. If the underlying investments perform well, you may get more than is needed to pay off the loan.
But if the underlying investment performs poorly, you could end up having to review the premium subscriptions to your endowment policy and/or the basis on which your mortgage is operated in order to ensure that the mortgage loan can still be repaid in full at the end of the agreed term.
With a pension repayment vehicle, you make your monthly repayments of interest to the lender and you also make contributions to a personal pension. This personal pension then provides a tax-free lump sum as well as a taxed regular income at retirement. Most, if not all, of the lump sum is used to clear your mortgage loan at that date.
On the good side, pension contributions qualify for tax relief of up to 40% (for a higher rate taxpayer), which boosts the value of every pound you contribute to your pension.
However, using your tax-free lump sum as a mortgage repayment vehicle may leave you with inadequate income in retirement. Also, the lump sum is payable on retirement, so your loan term may be more than 25 years (depending on how old you are and when you are planning to retire!). The biggest problem is that poor performance could adversely affect the amount of the tax-free lump sum resulting in insufficient funds available to repay the loan at the end of the agreed term.
Using an ISA as a repayment vehicle, you make your monthly repayments of interest to the lender and you also make contributions to an Individual Savings Account (ISA). Like the PEP mortgages which preceded them, ISA mortgages use stock market-based investments for tax-free growth.
There are two main types of ISA: "mini" and "maxi". There are different rules over contribution levels and range of investments available in each.
On the plus side, if your ISA performs well, you may be able to pay off your mortgage early.
However, a stock market crash could leave your investment in trouble. Also, current tax rules dictate that the maximum investment in an ISA is £7,000 per annum, which won't be enough to give you confidence that you will be able to repay a large mortgage at the end of the term.
With so many different types of mortgage in the marketplace, you could be forgiven for not understanding all the different types of mortgage or for being confused.
The main differences in the types of mortgage can generally be applied to both repayment and interest only mortgage options - and they will affect the amount of interest you pay and for how long. Each different type will be more or less suitable depending on your life stage and your personal circumstances so it's important you fully understand all the options out there and how they work. Take time to read through this section before you feel comfortable that you've come to a choice on your mortgage type.
The different types of interest options and mortgages available will often be on special offer from different lenders. Our advisers will be able to help you with this.
Select from the list below to find out more about the different types of mortgages.
John Charcol is not authorised to offer investment advice. We recommend you seek professional advice with regard to these topics if you believe they may affect you.
A discount rate mortgage charges an interest rate that is linked to a lender's standard variable rate (SVR) - and it will be reduced by a specific amount for an agreed period of time.
During the agreed discount period the interest rate charged can go up and down if the SVR of the lender changes. Therefore, if the SVR goes up, your payments will rise and, likewise, they will fall if the lender's SVR goes down. The interest rate that you pay will always, however, be reduced by the exact discount rate agreed at the start of the discount period.
At the end of the discount period, the mortgage will revert to the lender's standard variable rate and your payments will increase.
Discount rate mortgages can be useful if you expect to have more money available to spend on your mortgage at a specific time in the future i.e. when the discount rate will end. You should always make sure that you can afford the payments at the end of the discounted rate period and also that you have factored in potential rises in interest rates during the discount period.
A capped rate mortgage guarantees that the interest rate charged on it will not rise above a certain level for an agreed period.
This means that your mortgage payments are protected against rising interest rates for a set period and you have the peace of the mind that they will not rise above a certain amount. Although payments will not rise above an agreed amount for a specified period, you will however enjoy reductions in your monthly payments if your lender's standard variable rate (SVR) falls.
Therefore, capped rate mortgages offer the best of both worlds - security in that you know your payments can only go so high plus the benefit of reductions in your payments should the lender's rate fall.
The capped rate itself i.e. the top level of interest that you can be charged during the agreed rate is generally a little higher than you might pay on a fixed rate mortgage over the same period. Capped rate mortgages generally revert to the lender's standard variable rate at the end of the agreed 'capped' period.
Capped rate mortgages are useful if you want to set a maximum amount that you would like to pay over a set period and you feel that mortgage rates may rise higher.
Capped rate mortgages often have an early repayment charge. Normally, this only applies during the 'capped' period itself but can, depending on the lender, extend beyond this period.
A fixed rate mortgage gives you peace of mind for a specific period of time as your interest rate and mortgage payment are fixed i.e. they will not change during the agreed period or term.
Fixed rate mortgages are available for many different periods of time - two years, five years and ten years are typical examples but there are different fixed periods available including periods longer than ten years.
One disadvantage of fixed rate mortgages is that you will not benefit from any fall in interest rates during your fixed period and your payments will remain exactly the same. At the end of the fixed period your payments will generally revert to the lender's standard variable rate (SVR).
Fixed rate mortgages are very popular and are very suitable for people who want to know exactly how much they are going to be paying each month. They will also protect you against rising rates.
Fixed rate mortgages often have an early repayment charge which will vary from lender to lender. Normally, this only applies during the fixed period itself but some fixed rate mortgages do have repayment penalties beyond this period.
A tracker mortgage or (tracker rate mortgage) is a variable rate mortgage that will track the Bank of England base rate at a set amount above or below for a fixed period.
Therefore, for the agreed 'tracker' period the monthly payment on the tracker mortgage will vary in line with any changes in the base rate. Put simply, if the base rate goes up, your payments will rise and if it falls then so will your payments. The different between your tracker rate and the base rate during the fixed period will not vary.
A tracker mortgage is useful if you want to be able to benefit from falling interest rates but you must be certain that you can afford any increases as well.
At the end of the fixed 'tracker' period your payments will normally revert to the lender's standard variable rate (SVR) or to a higher margin above the base rate.
A cashback mortgage offers you a cash lump-sum at the beginning of your mortgage. This is a normally a fixed percentage of your total mortgage but it can be an agreed amount also.
If you take out a mortgage for £100,000 with a 4% cashback, you will receive £4,000 on completion of your house purchase or remortgage.
There are no inherent negatives of a cashback mortgage but you should be wary of a higher than normal interest rate or early repayment fees that may negate the value of the cashback received.
Offset mortgages and current account mortgages are similar in that they use monies in current accounts or saving accounts to reduce monthly mortgage payments. However, they work in slightly different ways.
With an offset mortgage your, your main bank account or savings account (or both accounts) are linked to your mortgage. These accounts are normally also with your lender. The way they work is that the amount you owe on your mortgage is reduced by the amounts held in these accounts before calculating the interest due. As the amounts held in your bank accounts rises or falls, you are charged less or more interest on your mortgage accordingly.
For example if you have an 'interest only' mortgage of £100,000 and savings or a current account balance of £25,000, then you are charged 'interest' on the remaining £75,000 only. If the difference between the mortgage and bank accounts changes, then the interest charged will change.
Often, monthly payments will remain at an equal amount and 'overpayments' are used to reduce the overall mortgage debt. This is how you can pay off your mortgage early and save money with an offset mortgage. Some lenders will amend the monthly mortgage payment instead so that you benefit from lower payments but, of course, you won't be able to pay off your mortgage early.
Offset mortgages and current account mortgages are similar in that they use monies in current accounts or saving accounts to reduce monthly mortgage payments. However, they work in slightly different ways.
A current account mortgage is similar to an offset mortgage in that it reduces the overall amount 'owed' when your savings or current account balance are taken into account. However, the mortgage and current/savings account are normally combined into a single account rather than being separate as with an offset mortgage. The account is effectively acting like one big overdraft.
The lender normally stipulates a minimum amount that needs to be left in the account each month to repay your mortgage over the agreed period. If there is a surplus, then you will pay less interest and pay off your mortgage early. Similarly, if you leave less than the required amount in the account, you will end up paying more for your mortgage.
A current account mortgage also normally has the typical features of a current account such as a cheque book, access via cash machines, direct debits etc.
Current account or offset mortgages are of particular benefit to higher rate taxpayers who may have substantial savings to 'offset' against their mortgage - and who like the flexibility of overpayments or underpayments. They may not be of much benefit if you don't have many savings to 'offset' or if lower interest rates or other features are of greater importance.
As a first-time buyer mortgages can be very confusing. It's therefore very important that you get the right first-time buyer mortgage with the right interest rate and terms.
It's also important, as a first-time buyer, that you are sure of how much you can afford pay each month and what effect a rise in interest rates may have on your monthly payments if you are paying a variable rate mortgage.
Our section with mortgage calculators will help you make a decision on how much you can afford each month.
Buy-to-let mortgages have become very popular, there are those who find themselves as 'accidental landlords', but more and more people in the UK now own second homes as investments.
Buy-to-let mortgages differ from standard mortgages in that the amount banks or building societies will lend is assessed upon the expected rental income of the property rather than personal income. However, following the arrival of MMR in April 2014, personal income has become more relevant when the lender looks at the overall picture. It is usual for not more than 85% of the purchase price to be available on a buy-to-let mortgage, meaning that you will need a minimum of a 15% deposit.
Lenders may also impose other restrictions or conditions on applications for a buy-to-let mortgage such as UK residence, being 21 or over as well as being an existing homeowner. It is also expected that the property will need only minimal improvements before being rent worthy.
For further information please see our dedicated section on buy-to-let.